Purchase of Business: Purchase Consideration, Methods

Meaning of Purchase of Business

Purchase of Business generally means buying of one business firm by another business firm. But the term is used differently in different cases. ‘Purchase of Business’ basically refers to the acquisition of a sole proprietorship firm or a partnership firm or a company by a limited company.

Acquisition of a limited company by another limited company is not called ‘Purchase of Business’. It is called ‘‘Amalgamation’’ or “Merger”.

Therefore, the purchase or acquisition of the business by a limited company generally refers to the purchase of a non-corporate form of a business organization like sole proprietorship or partnership form of business by a company.

Purchase of business by a limited company may take any of the following two forms:

  1. An existing company may purchase an existing sole-proprietorship or partnership business.
  2. A new company may be formed to take over an existing business of a sole proprietor or a partnership firm, i.e., the existing business unit may be converted into a limited company.

Purchase Consideration

Purchase consideration’ means the purchase price payable by the company for the business acquired. Generally, an agreement is made between the company and the vendor (the firm which is going to be sold out) which contains the terms and conditions of the acquisition of a business.

The basis for determining the purchase consideration, and the mode of payment of the purchase consideration. Hence, at first, the purchase consideration is to be determined.

Consideration, i.e., the purchase price may be paid in cash, in shares & debentures of the purchasing company or in both cash and shares & debentures. The meaning of consideration is defined by the ICAI in Accounting Standard 14 in the following way:

Consideration for the amalgamation means the aggregate of the shares and other securities issued and the payment made in the form of cash or other assets by the transferee company to the shareholders of the transferor company.

Basis for Calculation of Purchase Consideration

The purchase price payable is the money value of Consideration. Therefore when the consideration is calculated there must be a certain basis. For this the following points are considered:

  1. The value of the tangible assets acquired by the company as per agreement.
  2. The amount payable for goodwill.
  3. The amount of liabilities of the vendor firm to be taken over by the purchasing company.

Methods of Purchase Consideration

In this section, we will discuss the different methods for calculating the amount of purchase consideration. Depending on the terms and conditions of acquisition of business the basis for determining the purchase consideration also varies from case to case.

The following are the different methods generally used for determining the purchase consideration:

  1. Lump Sump Method
  2. Net Assets Method
  3. Payment Method
Methods of Purchase Consideration
Methods of Purchase Consideration

Lump Sump Method

When the purchasing company agrees to acquire the business of the vendor firm by paying a lump sum amount it is known as a ‘‘Lump-sum basis’’.

For example, Assam Trade Company Ltd is formed to take over the assets and liabilities of M/s. Sarma Brothers for a consideration of Rs. 20,00,000 to be discharged in fully paid shares of Rs. 10 each. This amount of Rs. 20,00,000’ is termed as Purchase Consideration under ‘Lump sum basis’.

Net Assets Method

Under the Net Asset method, purchase consideration is equal to the total value of Net Assets taken over by the company from the firm.

The amount of Net Assets is ascertained as under:

The total value of Net Assets = (Total agreed value of fixed assets taken over by the Company + Total agreed value of current assets taken over by the Company) – Total liabilities agreed to be paid by the Company.

Payment Method

Sometimes, the agreed values of assets and liabilities, taken over by the purchasing company may not be given in the question. The problem specifies the payments to be made by the company in cash/shares/ debentures etc.

In such cases, the amount of purchase consideration is arrived at by adding all the payments made by the purchasing company irrespective of the form of payment such as cash, issue of shares, issue of debentures, etc.

Under this method, while calculating the amount paid in the form of issue of shares and debentures, the issue price of such shares and debentures and not their face value is to be taken into account.

This method of ascertaining purchase consideration is known as the ‘Payment Method’. Under this method purchase consideration is calculated as under:

Cash PaidXXX
Issue Price of Equity Shares, if anyXXX
Issue Price of Preference Shares, if anyXXX
Issue Price of Debentures, if anyXXX
Total Payment is the amount of purchase considerationXXX

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